Great technology! Pity about the value Thursday 6 Apr 2017

Improving investment success in tech companies.

In a corporate environment preoccupied with the risks and opportunities of disruptive technology, the inadequacies in investment appraisal are alarming. Many early-stage tech companies starve through lack of funds. Others feast on funding before fading to irrelevance. Some thrive.

In an attempt to pick the winners, some investors use this beguilingly simple formula:

At this stage let’s assume that the first two components of the equation have been appropriately assessed. In other words:

The technology is better than alternatives in a way that is economically beneficial

The target market is well defined and has enough size, growth and margin to provide an attractive return on investment.

The third leg of the equation is often misconstrued – leading to false hopes of sustainable differentiation, earnings and risk.

The mere existence of IP does not protect differentiation. Quality of protection ranges from ‘commercially useless’ to ‘economic blockbuster’. If the IP provides strong, enforceable rights over the important features of a technology, this yields the high value promised by the formula. However, if legal protection is weak and the technology is easy to copy, then competitive advantage will erode quickly. Value (to the inventor) will be low – but copycats might benefit from the investment!

Despite the complexity of IP, it only takes the addition of a single word to validate the equation:

How can one assess the quality of IP protection? Consideration should be given to a range of legal rights.

Patents: Patents are subject to a lengthy and complex examination period, during which the scope of claims can narrower significantly. So the first question is whether a patent has been granted. Even after grant, patents provide little commercial advantage if the claims don’t cover important dimensions of the technology, or if they are easy to design around, or hard to enforce. The flip side of the coin is that a valid patent providing broad coverage of key features can be extremely valuable. In economic terms, such an asset protects volume & margin premiums, and extends the useful life of the technology.

Trade Secrets: The term ‘secret’ is easy to use. In practice, secrets are hard to keep. Rigorous contracts and robust procedures are required to maintain confidentiality. The value equation doesn’t hold true if controls don’t prevent inadvertent disclosure, or if contracts don’t adequately protect against disclosure by employees and suppliers. Another potential gap in the equation is that trade secrets provide no protection from third parties reverse engineering the technology or creating similar inventions of their own.

Copyright: This is an unregistered right that can protect documented know-how, designs, integrated circuit designs, and computer software code. However, in the context of technology, copyright protects the expression of the work and not the idea or process underlying the work. Remember that, in the absence of assignment, copyright is owned by its creator rather than funder.

Designs: Protect the visual design of objects that are not purely utilitarian. In most jurisdictions these have to be registered, and provide little protection if the design is not a driver of functional differentiation.

Further complications arise from IP being jurisdiction specific. Strong rights in your home market do not imply protection in other region.

Don’t forget the patent landscape! Even if your investment target has strong protection of its technology, this does not guarantee freedom to use it without infringing patents owned by other parties. This raises the risk of litigation or royalty outflows.

Gauging the economic strength of IP is complex. We recommend a value-based assessment prior to investment. A previously published article, IP Valuation & Capital Raising, provides a case study illustrating the use of a Tech Rating to support a valuation.